Tuesday April 24, 2007 by X
Hammertime – Evaluating ‘dog’ stocks
With the ASX recently continually breaking through to new highs, it is becoming increasingly difficult to find plays with the potential to generate substantial returns.
Our analysis of the market has yielded a brief list of ‘dogs’ – stocks that have been colloquially ‘hammered’ by the market, some with reason, some without. Those with a high appetite for risk and a longer time frame may find the list of such stocks below warrant further research, to the end of longing or shorting. This is merely a reporting of a screen, and not a recommendation to trade – this breed of beast may well double by this time next year, but could just as soon become insolvent in the 588G sense of the term.
IBA, PSA, PSH, GTP, CAA, CEY, MXI, NAM
It is worthwhile noting that companies such as these most frequently encounter one of two fates:
(1) Recovery. The company and/or conditions recover and the share price is substantially marked up when the inherent value in the stock becomes more apparent to the market. Recent examples include Coles Myer (CML, now CGJ) which was trading around $6 a few years ago whilst the restructuring was in full swing. PE firms wouldn’t touch it. Now a final buyout price in excess of $17 is all but set in stone.
(2) Bankruptcy/Liquidation. Where the issues affecting the company cannot be resolved, the outcome is often bankruptcy or liquidation because the business cannot be sustained as a profitable going concern. The late Sons of Gwalia (SGW) and automotive components manufacturer Ion (ION) are two prominent examples.
When considering the likelihood of each of the above scenarios, it is prudent to first develop a methodology of evaluation, applying a logically proceeding process of interogation, such as:
(1) What is(are) the issue(s) affecting the company
(2) Are they temporary or chronic?*
(3) Is management competent enough to deal with them, and period for that matter?
Further, there is no substitute for understanding the business itself when evaluating the effect of a piece of news. Much of the market’s overreaction to any item of new information is caused predominantly by the incomplete and ill-researched knowledge of market participants who, as a result, extend the reaction to a magnitude that is oft beyond logic.
*This is the crucial question to ask, a conjecture supported by Warren Buffet. Several years ago, in 2003, poker maching manufacturer Aristocrat Leisure (ALL) reported a sour deal in South America, resulting in the share price being savaged by 80% to below $1. Blind Freddy could see it was one deal gone bad, not a company breaker. It now trades $16.50. We recommended and purchased it at the time at $1.69 but have since sold the position. Where a negative announcement concerns a matter which does not threaten the company’s viability as a going concern, but rather a temporary issue such as a write-down or single failed project in a portfolio of many, then there is often opportunity to purchase stock at good value. It is an outcome of fear, where the excessive selldown reaction results because the market sees akin to a discontinuous bridge instead of a pothole. When the pothole is subsequently recognised for what it is (this may take anywhere from a few minutes to a few of years), the market corrects the overreaction and those who saw a pothole in the first place profit handsomely. This strategy has been tested numerous times (for example QBE, bought $7.12 after September 11).
